ECO 2503 University of Toronto

Syllabus, Fall 2010 Department of Economics

Syllabus for ECO2503:

Financial Economics for MFE Students
Asset Pricing and Portfolio Theory

The aim of this course is to survey the major asset theories, tools and results in
portfolio choice and asset pricing. Although modern finance is a highly mathematical
field, we will use mathematics only to enhance our understanding — “the major hurdles
in Finance are conceptual rather than mathematical” (John Cochrane). Most of the course
will focus on ‘classic’ asset pricing which is the foundation for any finance course that you
might take here at UofT or elsewhere. As this class is intended to be a survey course, I
want you to get “the big picture”, both conceptually and with respect to applicable tools.
My main objective is that in five years time you will be able to look at a research paper
and be able to understand its gist and to be able to read beyond the introduction. We will
not go through institutional details, I leave this for your securities courses (CSC). I will
not cover accounting related questions either, these will be covered during the accounting
review and they will also be touched upon in your financial modelling module. You
are expected to read the business section of at least one major newspaper (Wall Street
Journal, Financial Times, The Globe and Mail, etc.).

Exams
There is a mid-term exam and a final. The mid-term takes place during class on Octo-
ber 21; we start at 4 p.m. sharp. The final takes place in December after classes have
concluded; the date is TBA.

Assignments
There will be two assignments, one in portfolio theory, the other in asset pricing. Both will
relate to practical and empirical aspects and are thus aimed to complement the theoretical
material covered in class. They will require a serious time commitment on your part so
do not plan to complete them within two days of the deadline. Each assignment will be
graded and must be submitted in electronic form.

1 Andreas Park
ECO 2503 University of Toronto
Syllabus, Fall 2010 Department of Economics

Grading Policy
• Final: 45%

• Midterm: 30%

• Assignments: 12.5% per problem set (25% overall).

If your score on the final is better than on the midterm, then the midterm does not count
and its weight is automatically shifted towards the final. To pass the course you must
obtain a grade of 70% or higher in either the midterm or the final. To obtain an A+/A/A-
you must get a score of at least 90/85/80 on at least one of the exams (midterm or final).
If you miss this condition, then your grade will be adjusted downward to the next GPA
level. Example: Suppose you had 100% on both assignments and 80% on both midterm
and final. The computed grade would be 85%, but since your best grade on an exam was
80%, your course grade will be 84%.

Appeals. If you appeal to re-grade one of the problem sets or exam questions, I will
re-grade the entire problem set/exam. Note that this may lead to a lower overall grade.
Your complaint has to be in writing and you must give a detailed outline as to why and
where you think that the assessment is inaccurate.

Missing a Midterm: There are no “make-up”-tests — weight will automatically be

shifted towards the final.

Not handing in an assignment problem set. If you miss the deadline for an as-
signment, you should contact me immediately. The rule is that your score gets reduced
by 5% per late day.

Plagiarism is a severe academic offence. Please note the following disclaimer

“Students agree that by taking this course all required papers may be subject
to submission for textual similarity review to Turnitin.com for the detection
of plagiarism. All submitted papers will be included as source documents
in the Turnitin.com reference database solely for the purpose of detecting
plagiarism of such papers. The terms that apply to the University’s use of the
Turnitin.com service are described on the Turnitin.com web site.”

By submitting a problem set you certify that you have read and understood the uni-
versity’s policies on plagiarism. Please also consult the university’s website on academic
writing: http://www.utoronto.ca/writing/plagsep.html.

2 Andreas Park
ECO 2503 University of Toronto
Syllabus, Fall 2010 Department of Economics

If I detect plagiarism, I will go through the standard process for academic misconduct.

Further Information
Class Times: Thursdays 4-6pm
Room: GH100
My office: GH210
Office Hours: TBA
Phone St. George: 416 - 978 - 4189
Email: andreas.park@utoronto.ca
Course Webpage: on Blackboard.

I kindly ask you to respect my office hours.

Information about the Blackboard System

What follows is a copy of the university’s official statement (not corrected for typograph-
ical errors).

Logging in to your Blackboard course website. Like many other other courses,
ECO2503 uses Blackboard. To access the ECO2503 website, or any other Blackboard-
based course website, go to the UofT portal login page at portal.utoronto.ca and login
using your UTORid and Password. Once you have logged in to the portal using your
UTORid and Password, you’ll find the link to ECO2503 course website along with the
link to all your other Blackboard-based courses.

Activating your UTORid and password. If you need information on how to acti-
vate your UTORid and set your password for the first time, please go to www.utorid.
utoronto.ca. Under the “First Time Users” area, click on “activate your UTORid” if
you are new to the University or “create your UTORid” if you are a returning student,
then follow the instructions. New students who use the link to “activate your UTORid”
will find reference to a “Secret Activation Key”. This was originally issued to you when
you picked up your T-card at the library. If you have lost your “Secret Activation Key”
you can call 416-978-HELP or visit the Help Desk at the Information Commons on the
ground floor of Robarts library to be issued a new one. The course instructor will not
be able to help you with this. 416-978-HELP and the Help Desk at the information
commons can also answer any other questions you may have about your UTORid and
Password.

3 Andreas Park
ECO 2503 University of Toronto
Syllabus, Fall 2010 Department of Economics

Email communication with the course instructor. At times, the course Instructor
may decide to send out important course information via email. To that end, all UofT
students are required to have a valid UofT email address. You are responsible for ensuring
that your UofT email address is set up AND properly entered in the ROSI system. You
can do that by using the following instructions:
To submit the information to activate your UTORid and Password (see above), you
will need to click the “Validate” button. Follow the instructions on the subsequent screens
to receive your utoronto.ca address. Once you have your UofT email address go to the
ROSI system, (www.rosi.utoronto.ca) log in and update the system with your new
institutional email address.
You can check your UofT email account from either

1. The UofT home page http://www.utoronto.ca/ (Choose “quick links” - choose

“myutoronto.ca” - enter your UTORid and Password - choose “webmail” Or

2. Via Outlook, Mozilla etc. Visit the helpdesk at the information commons for help
with the set up.

Forwarding your utoronto.ca email to a hotmail, gmail, yahoo mail or other types of
accounts is not advisable. In many cases, hotmail/gmail/yahoo automatically filters email
from any utoronto.ca address into the junk mail folder. Therefore emails from your course
instructor will end up in your junk mail folder.
You are responsible for:

1. Ensuring you have a valid UofT email address that is properly entered in the ROSI
system;

2. Checking your UofT email account on a regular basis.

The official statement ends.

Literature
There are many excellent finance books available, but most are either geared towards an
MBA/undergrad or towards a doctoral student audience. None of the books that I know
of covers all the topics in this course. I have collected materials from several sources
and I cannot in good conscience provide a unique textbook recommendation. Here are
my recommendations as based on the topics that are covered. The is a rumour that past
generations of students have assembled a folder that contains copies of all listed references.
I cannot endorse copying this specimen.

4 Andreas Park
ECO 2503 University of Toronto
Syllabus, Fall 2010 Department of Economics

For some topics, I will also ask you to read the original literature. These papers will
be listed on Blackboard as we go.

1. Basics. Use either

• Thomes Copeland and Fred Weston: Financial Theory and Corporate Policy,
Addison-Wesley. Hereafter: CW. or
• Bodie, Kane, Marcus, Perrkakis, Ryan: Investments, 2006, McGraw-Hill.

These two texts are undergraduate textbooks in finance. They cover basic topics
nicely. Both, especially CW, also give decent introductions to more advanced topics.

2. Bond Pricing.

• Elton, Gruber, Brown, Goetzmann: Modern Portfolio Theory and Investment

Analysis, 2003, Wiley. Hereafter: Elton
A really nice text that has plenty of examples.
• David Luenberger: Investment Science, 1998, Oxford University Press. Here-
after: Luenberger.
This book is slightly below the level of this course, but it is useful for sev-
eral topics, including bond pricing, portfolio theory and CAPM. It is aimed at
students who have a math-oriented first degree.

3. Risk Management

• Basic concepts are explained in Elton; advanced topics will be covered with
original work.

4. Portfolio Theory, CAPM, and APT

• Basics can be studied from Luenberger, Elton, CW. Our approach will be based
on matrix algebra and this is best explained in:
• Campbell, Lo and MacKinley: The Econometrics of Financial Markets, 1998,
Princeton University Press. Hereafter: CLM.
Focusses mainly on empirics; sets up theoretical concepts so that they can be
empirically tested; very comprehensive. Useful source to learn about empirical
methods; it should be your first reference text when tackling the empirical
problem sets.

5. General Equilibrium Theory

5 Andreas Park
ECO 2503 University of Toronto
Syllabus, Fall 2010 Department of Economics

• Basics are explained in CW.

• Darrell Duffie: Dynamic Asset Pricing Theory, 2001, Princeton University
Press. Hereafter: Duffie.
My lecture on this topic is based on the first chapters of Duffie.

6. Consumption based Asset Pricing.

• John Cochrane: Asset Pricing, 2001, Princeton University Press. Hereafter: JC.
A very nicely written book which also covers a great deal of empirical methods.

7. Financial Market Trading

• Joel Hasbrouck: Empirical Market Microstructure (Subtitle: The Institutions,

Economics, Econometrics of Securities Trading), 2007, Oxford University Press.
This segment of the course will be based upon the first 6-7 chapters of this vol-
ume. Hereafter: Hasbrouck.
• Larry Harris: Trading and Exchanges: Market Microstructure for Practition-
ers, 2003, Oxford University Press.
This book is a nice read about trading terminology and mechanisms, but does
not include the models that we discuss in class. If you do your internship in
trading you may want to get this book.

Naturally, as the general public has a great interest in portfolio choice, there are many
“popular science” books. In some case these authors explain complicated concepts better
than textbooks. Prominent examples are

• Jeremy Siegel: Stocks for the Long Run, 2002, McGraw-Hill.

A modern classic for investors.

• Robert Shiller: Irrational Exuberance, 2000 (March), Princeton University Press.

The Guardian labelled him the “Party Pooper” – his book came out just months
before the New Economy stock market bubble burst, when everything still seemed
jolly-good. Shiller allegedly has planted the phrase Irrational Exuberance into Alan
Greenspan’s mind (who famously used the phrase in a 1996 speech before congress).

There are several finance related movies that may be worth watching. The classic is “Wall
Street” (and, some time this term, “The Return of Gordon Gecko”), but “Boiler Room”,
“Trading Places” and “Barbarians at the Gates” are also worth watching.

6 Andreas Park
ECO 2503 University of Toronto
Syllabus, Fall 2010 Department of Economics

Course Structure
The details of the course structure and of the topics covered will be displayed on the
Blackboard system. Most (but not all) material is on slides.
In general, we will deal with two big questions: first, what determines economic agents’
investment decisions, and second, how are financial assets priced, given agents’ investment
decisions. We will also discuss the role of information in portfolio choice and asset pricing.
As subfields of finance, we will then cover the following topics:

• Individuals investment decisions under uncertainty and over time.

• Portfolio theory and asset pricing, in particular, general equilibrium theory and the
Capital Asset Pricing model.

• Arbitrage Pricing Theory and Consumption Based Asset Pricing.

• Efficient capital markets and asset pricing with asymmetric information.

• Basics of financial market trading.

This translates into the following tentative schedule for our lectures:

Topic 1 Basics, Net Present Value, Internal Rate of Return CW Ch. 1,2. Luen Ch. 2,
Duffie Ch. 1

Topic 2 Bond pricing, the yield curve, term structure of interest rates. Luen Ch. 3-5.
Elton Ch. 20, 21.

Topic 3 Risk management: Utility, choice under uncertainty, expected utility, prospect
theory, puzzles in choice under uncertainty. Luen Ch. 9, Elton 10, 11.
Measuring risk and risk aversion. Intertemporal choice, state-price density. JC Ch.
1-3. Luen Ch. 9.

Topic 4 Asset Allocation and Portfolio Choice; Markowitz’s Mutual Fund Theorem.
Luen Ch. 6, Elton Ch. 4-9, CLM Ch. 5.

Topic 5 CAPM. Luen Ch. 7-8, Elton Ch. 13-15, CLM Ch. 5,6

Topic 6 General Equilibrium, efficiency, state prices, the law of one price, arbitrage.
Luen Ch. 9, Varian: “Principles of Arbitrage”, Journal of Economic Perspectives,
1987; Duffie Ch. 1.

Topic 7 Arbitrage Pricing Theory and other multi-factor models. Elton Ch. 16, 24.

7 Andreas Park
ECO 2503 University of Toronto
Syllabus, Fall 2010 Department of Economics

Topic 8 Consumption Based Asset Pricing, the equity premium puzzle ICAPM JC Ch.
1-9, CLM Ch. 8, Duffie Ch. 2.

Topic 9 Efficient Financial Markets. Elton Ch. 17, CLM Ch. 2, 4.

Topic 10 Organization of Market trading, market maker models, asymmetric informa-

tion. Hasbrouck, Ch. 1-6.

8 Andreas Park